Fourth Down Week Brings Market Back to
October

IN A BEAR MARKET, good news is quickly stripped of its power to please and hints of trouble are granted unquestioning credence.

This being a bear market until proven otherwise, investors found fault with an apparently strong employment report Friday while wringing their hands at terrorism warnings, pushing share prices lower to finish out a fourth straight losing week.

Under the smothering pressure of grinding, low-volume selling and a lack of eager buying, the broad market slouched to levels last seen just two days after the latest index lows were set in early October. The Standard & Poor's 500 lost 26 points, or 3%, to rest at 829, its lowest close since 803 on Oct. 10, the day it surged from the panicky depths of 776. The Dow Jones Industrials pulled back by 189 points, or 2.4%, to close at 7864, a value last seen Oct. 12.

Though the momentum of the declines frequently eased and traders never let the indexes settle at their daily lows, the proximity of those October levels spurred the predictable speculation about another visit there.

The Nasdaq dropped 38 points, or 3%, to 1282, last week. Yet the index remains 15% above its October bottom tick, a testament both to tentative optimism for a technology turnaround and to the enormous losses it sustained prior to the rebound.

The economic data that dotted the week proved generally better than expected, while doing little to alter the perception that the current recovery remains tentative, sporadic and somewhat fragile. A report on manufacturing activity came in stronger than forecast, though a reading on productivity in the fourth quarter slipped. Most prominently, the January employment numbers showed an unexpected drop in the unemployment rate to 5.7% from 6%, and a 143,000 jump in the job total that effectively reversed December's 156,000 decline.

Economists, however, swiftly assailed the reliability of the figures, given seasonal factors and a recent change in the government's statistical methodology. Any optimism engendered by the Friday report quickly dissipated on word that the White House had raised the country's terrorism alert status, based on threats gleaned from intelligence channels.

Of course, this was not the only reminder of global conflict. In a week when the Secretary of State delivered an exhaustive array of evidence of alleged illicit weapons programs in Iraq, the seeming readiness of the president to move toward military action kept traders back on their heels.

In yet another reminder, oil prices ran to $35 a barrel, with a squeeze in heating oil supplies augmenting the persistent "war premium" in the price. With oil prices sticking well above $30 so far this year, estimates of consumer activity in the first quarter are already being revised downward.

The idea that a rapid resolution to the Iraq standoff will knock oil prices lower, bolster investor confidence and recharge the economic recovery remains a pervasive, if pat, belief on Wall Street. This is one reason, most likely, that stock buyers consistently emerge to nibble at stocks when the indexes slide. The desire to ride a possible postwar rally wrestles with the instinctive fear of international discord and the unknowable course of war.

The investment community sees a war as a crucial fulcrum for market fortunes, in part because the corporate news hasn't offered much reason for excitement. Companies generally have met expectations for the last quarter, but have been almost universally cautious in tamping down expectations for profits this year. And now that earnings season is nearly complete, Wall Street has few other identifiable catalysts on the immediate horizon.

Federal Reserve Chairman Alan Greenspan testifies on Capitol Hill on Tuesday, of course. But traders eyes remain fixed elsewhere in the District, as each news bite from the White House and Pentagon sends stocks darting. The possibility of war isn't the only important variable that should concern investors, but for now it holds that status in the popular perception.

It's been a far colder and snowier winter in the Northeast than last year. But in so many other ways, Wall Street feels like a replay of early 2002.

There is -- and was -- a widely shared belief that the bear market was nearing its end, having experienced a climactic and emotional tumble the previous autumn, only to recover powerfully during the fourth quarter. This year -- same as last -- it's common to hear people say stocks would surely be higher if not for some daunting "exogenous" factors. Last year, it was the pervasive concern about more terrorist attacks and the Enron-led parade of corporate scandal. This year, it's the prospect of war in Iraq and confrontation with North Korea.

A year ago, of course, it eventually became clear that -- never mind the scandals -- the economy wasn't growing fast enough to drive corporate profits to levels that could satisfy hopeful investors and justify stock valuations.

One other, related echo of last year is the way that analysts are pinning all hopes for a strong acceleration in corporate earnings on a second-half surge.

Chuck Hill, research director and chief earnings tracker at Thomson First Call, notes that in recent weeks the forecasts for the first and second quarters have been reduced at a rapid rate. With companies warning of earnings shortfalls for the current quarter at a rate of 2.5 times those raising forecasts, the consensus projection for first-quarter year-over-year growth for S&P 500 earnings has fallen to 7.6%, down from 11.7% on Jan. 1. The expected increase for the second quarter is almost the same, at 7.7%.

In the latter half of the year, the pace of profit gains is seen quickening to 15% in the third quarter and more than 22% in the year's final three months. Those strong gains are penciled in even though the comparisons will begin to get tougher after midyear, given that profits began to rise later in 2002.

Hill says that last year, his firm declared firmly that estimates for the latter quarters were way too high and were based on questionable assumptions about a capital-spending revival. "That was an easy call," he says. This year, it isn't clear whether cost-cutting and capacity reductions have made the second-half comeback more plausible. "But the obvious [direction of the] risk is down."

One meaningful difference between this year and last is that stock valuations are far more reasonable, if not generally cheap, today, based on operating profits and not reported "all-in" results. Operating earnings of S&P 500 companies for the full year are expected to be about $53, almost exactly what was forecast for 2002 at this time last year. Actual '02 results were closer to $48. Today, the S&P index, at about 830, shows the market valued at less than 16 times expected earnings. Last year, the index was above 1100, or more than 20 times then-estimated profits.

That's the good news. The bad news is that the second-half surge will have to arrive on schedule for share prices to rise, or even to steady themselves, at today's levels.

The scorching outperformance of tech issues since the market's October low has drawn the attention of every Wall Street watcher, yet there's no harmony of opinion on why it has happened, if it will last or whether it's a good thing.

Since early October, the Dow and S&P 500 are up 7% to 8%, the Nasdaq has climbed 15% and the Morgan Stanley High Tech Index -- a relatively pure gauge of the sector's performance -- is up 20%.

In the tech-pundit community, skeptics say the rush back toward tech is yet another (temporary) victory of hope over experience and analytical reasoning, and they point out that the leading group from a previous bull market is almost never the one to lead the resurgence. Believers in the tech move insist it signals that the technology economy has stopped worsening and the smart bet is on a recovery later in 2003 and into 2004.

What's undeniable is that tech continues to be the most expensive major sector based on expected earnings for this year. The tech representatives in the S&P 500 are trading at 24 times expected 2003 earnings, compared with about 16 times for the index as a whole. And those earnings are expected to surge by 30%, an aggressive consensus forecast. Given that these stocks remain more volatile and therefore potentially risky, paying a premium for them strikes some as perverse, a vestige of New Economy exceptionalism.

The Merrill Lynch technology research team led by Steve Milunovich remains cautious on tech prospects, mostly because it doesn't expect the larger economy to accelerate or capital spending to surge strongly. Merrill also notes that while earnings forecast patterns in tech have improved from year-earlier levels, they are merely falling more slowly now. Last week,
Cisco Systems
and
Dell Computer
notably offered sober outlooks for the year. And don't forget that in January of last year, tech earnings projections briefly turned higher in what effectively was a false spring for the industry.

Yet investors are showing a higher comfort level owning tech shares, at least those of the larger, more stable leaders such as
IBM,Microsoft
and Dell. One statistical indicator of this relative calm is the level of the Nasdaq volatility index (known as the VXN), which measures the fear level embedded in options on the Nasdaq 100 index. It is almost unchanged this year, even as the CBOE Volatility Index (or VIX) has jumped by more than 35%.

That could mean a dangerous complacency has crept into the tech sector. Or, perhaps, that the more generalized worries about war and the economy are manifesting themselves more acutely in the broader market instruments.

Professional money managers remain "underweighted" in tech, according to surveys, meaning they own less than the sector's portion of the index. Arnie Berman, strategist at SoundView Technology Group, believes fund managers raised their commitment to tech to get a piece of the fourth-quarter Nasdaq rally, and they now sit static.

In his travels among portfolio managers, Berman says he finds they are taking "an aggressive wait-and-see stance. They have the ability to talk themselves out of any decision."

As if to accentuate the divergent opinions surrounding tech, Merrill's Milunovich says, without prompting, "Some fund managers feel tech is bottoming. A lot are trying to talk themselves into buying."

Apparently, many market pros are exercising their powers of persuasion in front of the mirror, to mixed effect.

Berman thinks tech's weighting in the broad indexes is overstated because it's the only sector with more cash held by its companies than debt owed by them. In other words, if all companies' debt balances are added to their equity capitalization to arrive at enterprise value, tech's weighting falls significantly, making its valuation less extreme.

But that doesn't offer reassurance on the course of tech demand and earnings. Berman, who considers himself optimistic on full-year 2003 results, nonetheless admits, "I can find plenty of reasons to be nervous for the near term." Tough seasonal factors and accounting attitudes that discourage smoothing quarter-to-quarter results are two of them.

With expectations modestly improving for brighter results, investors will need constant positive reinforcement from companies. As Berman says, "Any month when the fundamentals haven't gotten better, people assume there will be another ugly re-test" of the latest lows in the tech sector. And at those times, they sell the stocks.

the food stocks have crumbled over the past couple of weeks. The big blow was struck by
Kraft Foods,
the leader and erstwhile investor favorite, which reduced its 2003 earnings outlook and disclosed a big surprise pension expense.

Investors, who become petulant these days when a stock perceived as safe bites them, reacted angrily to the earnings news and the sense that Kraft management lacks the desired discipline and disclosure habits. The stock, a top performer since its initial public offering in mid-2001, is down more than 10% since the news and hovering just above its $31 IPO price. Its earnings multiple, below 15 on new 2003 estimates, has gone from a premium compared with its peers to a slight discount.

Yet even analysts not enamored of the slow-growth, deflation-challenged packaged foods industry, such as Morgan Stanley's David Adelman, have come to the stock's defense, pointing out Kraft's exhibited ability to squeeze out top-line growth and its impressive free cash-flow generation. Top members of Kraft management, in either a deft PR move or a true expression of faith, bought several thousand shares of the stock right after it sold off.

There's been a lot of debate as to whether the more stable consumer-products names, such as food and beverage makers, would see investor cash rotate out of their stocks toward more cyclical areas. Some of that has happened, and if the stock market should take off these staples stocks would likely lag. But on the merits, Kraft appears a more reasonable bet than it's been since it came out of the old Philip Morris as a newly public company.

Traveling down the industry's food chain a bit leads to
H.J. Heinz,
a smaller and less heralded company. Unlike Kraft, which bulked up by acquiring Nabisco, and
General Mills,
which bought Pillsbury, Heinz recently shrank itself by merging its pet food, tuna and baby-food brands with
Del Monte Foods
to form a new company. What remain in Heinz are the core ketchup, condiment, sauces and frozen-foods units.

Heinz is avowedly focused on paring debt and maximizing cash flow. It's a beneficiary of a weaker dollar against the euro. Earnings for the fiscal year ending in April are projected at $2.30 a share, putting its P/E below 14, with the stock at 31.66. The company has said it will reduce its annual dividend now that the Del Monte deal is done, to a $1.08 annual rate, for a prospective yield of 3.4% based on current share price. That's well above the 1.9% and 2.5% respective yields of Kraft and General Mills.

As a group, incidentally, Wall Street analysts have few nice things to say about Heinz. That isn't necessarily a good thing, but it does leave room for pleasant surprise if the newly focused company can execute its plan.

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